ECON 600 – Economics of Organizations and Management

1. ECON 600 – Economics of Organizations and Management • Fall 2004 Professor Spry • Mondays: Minneapolis Section 21 • Terrance Murphy Hall 446 6:00-9:00pm • Tuesdays: St. Paul Section 5 • Roach Center LL01 6:00-9:00pm • Thursdays: Mall of America Section 86 • Metropolitan Learning Alliance, Room C 6:00-9:00pm

2. Topic 1: Applying Economics to ManagementToday’s agenda Syllabus & introductions The Nature of Economic Thinking • Opportunity Costs • Information and Incentives • Marginal decision making • Optimization • The equimarginal principle Very marginal group work Consumer Behavior Interwest HealthCare: p. 37

3. Topic 1: IntroductionApplying Economics to Management • Introductions: • Name/nickname, employer & position, educational background, goals for a managerial economics course…

4. Syllabus, Readings and Course Overview • Brickley, Zimmerman, and Smith • Moneyball by Michael Lewis • Author of Liars’ Poker about bond trading at Solomon Brothers • Coursepack • Allocation of Class time: • Lecture • Small group work • Discussions • Review assignments • Optional Presentations of Course Projects

5. A Systematic Approach to Managerial Decisions • People in both fields [stock market and baseball] operate with beliefs and biases. To the extent that you can eliminate both and replace them with data, you gain a clear advantage… Actual data from the market means more than individual perception/belief. The same is true in baseball. • John Henry (Boston Red Sox owner) as quoted in Moneyball p. 90-91

6. A Systematic Approach to Managerial Decisions Billy Beane has proven to be an exceptional general manager of the Oakland A’s • External environment: Small market baseball team battling Steinbrenner’s Yankees and other large market teams • Exceptionally low costs • Beane spends about $40 million on 25 players. • Yankees spend $126 million + cost of adding payroll in deals during the season, p.119 • Ratio of payroll of 7 highest and lowest teams • Baseball 4:1 • NBA 1.75:1 • NFL: 1.5:1

7. A Systematic Approach to Managerial Decisions Billy Beane has proven to be an exceptional general manager of the Oakland A’s • Outstanding product quality • Performance with Beane as general manager • 1998 74-88 • 1999 87-75 • 2000 91-71 playoffs • 2001 102-60 playoffs • 2002 103-59 AL West Champs • 2003 96-63 AL West Champs • 2004 81-56 currently in first place in the AL West

8. A Systematic Approach to Managerial Decisions The New England Patriots • External Environment: Collective bargaining agreement sets firm limits on all teams’ payrolls • Outstanding product quality: Two super bowl victories • Coach Belichick's college degree is in economics. • “He (Belichick) seems to view every decision as a chance to perform better cost-benefit analysis than his peers do. “ - NYT • Hired a Brandeis MBA to provide economic and statistical analysis of player personnel decisions. The A’s compete in different markets than your situation. • How do we take lessons from other industries or firms and apply only the relevant strategies to our unique situation??? Moneyball should be enjoyable, light reading

9. Fundamental Concepts People act in their own self interest which is not the same as being greedy! Information is asymmetric we don’t all share the same information assignment of decision rights must be compatible with access to information reward and evaluation systems must in turn be compatible with decision rights Adverse Selection – asymmetric information about attributes of agents Moral Hazard – self interested actions taken because another party has insufficient information to monitor performance

10. The Nature of Economic Analysis Formulating individual’s economic problem. Objectives or goals -Benefits Constraints -Costs Optimization Rational behavior by agents. Consumers, firms, and government. No unexploited profit opportunities. Equilibrium All agent’s optimal choices are compatible with the other agent’s choices.

11. Competitive strategy products and markets product characteristics production choices product pricing competitor behavior Internal structure decision rights (empowerment) compensation practices performance evaluation Course Overviewmanagerial economics and organizational architecture

12. Organizational Architecture: The Three-Legged Stool • The assignment of decision rights within the firm • The methods of rewarding individuals • The structure of systems to evaluate the performance of both individuals and business units

13. Four level of economic analysis of firms Neoclassical • Firm is a “black box” • Profit maximizing choice of price and quantity Industrial Organization • Market structure and game theory Contractual • Minimizing transaction costs and using information optimally Organizational Incentive • Principal-Agent Problems

14. Incremental Analysis Should you go for it on 4th down?? What is the conventional wisdom for coaches ( managers) on 4th down??

15. The equimarginal principle Should you go for it on 4th down?? take an action if marginal benefits justify marginal costs benefits and costs that have preceded the decision are sunk and therefore irrelevant to the decision If there is uncertainty, the expected value can be maximized by taking an action if the expected marginal benefits exceed expected marginal costs “He (Belichick) seems to view every decision as a chance to perform better cost-benefit analysis than his peers do. “ - NYT

16. The nature of opportunity costs Choices involve trade-offs play a round of golf or study for an exam spend a vacation at the beach or in the mountains The value of the foregone option is the opportunity cost of the option selected

17. Discussion • It takes 1 hr. to travel from New York City to D.C. by air, but it takes 5 hrs. by bus. If the air fare is $55 and the bus fare is $35, which is cheaper for someone whose opportunity cost of travel time is $3 per hour? For someone whose opportunity cost is $5 per hour? $7 per hour? • If you worked for Greyhound, what demographics would you target in your marketing? Why? • Would you expect Greyhound ticket sales to increase over the next 10 years? Why or why not? What does this suggest about future demand for products and services that help save time?

18. Tools for Optimization: The Derivative Slope = Rise / Run Derivatives let us calculate slopes for “funky,” non-linear functions, let Y=f(x) Tiny change in the exogenous (x-axis) variable from x1 to x2 we examine change in y=f(x) from f(x1) to f(x2) f’(x)=f(x2)-f(x1) ----------------- when x1-x2 is tiny x2 - x1 If f(x) = axb then f’(x) =abxb-1

19. Marginal AnalysisOptimizing performance Image climbing Mount Everest As you climb the slope is positive and it is hard to climb up a positive slope If you fall, you notice that the slope is negative and you don’t need to work to roll down like Wile E. Coyote Only on the top is the hill flat  slope=f’(x)=0 To optimize the value of f(x) it is necessary for f’(x)=0

20. Benefits and Revenues Total revenue (TR) are the total receipts from selling a good. Profit is total revenue minus total cost. Marginal revenue (MR) is the increase in total revenue from producing another unit of a good. Marginal cost (MC) is the increase in total cost from producing another unit of a good.

21. Optimization: Profit Maximization Price is a function of the quantity the firm sells. P = d(Q) The derivative of d with respect to Q is negative. d’(Q) < 0

22. Mathematics of Choosing How Much to Produce The firm’s total revenue (TR ) equals quantity times price. TR = QP TR = Q*d(Q) =TR(Q) Marginal revenue is the derivative of total revenue with respect to Q. MR = TR’(Q)

23. Optimal Choosing How Much to Produce The firm’s total cost of producing goods is a function of quantity. TC = TC(Q) Marginal cost is the derivative of total cost with respect to Q. MC = TC’(Q)

24. Mathematics of Choosing How Much to Produce Profit equals total revenue minus total cost. Profit = TR – TC To maximize profit, set its derivative equal to zero. TR’(Q) – TC’(Q) = 0 so TR’(Q) = TC’(Q) This equation says that marginal revenue equals marginal cost.

25. Special Case: A Price Taking Firm A price taker faces perfectly elastic demand. Marginal revenue equals price for a price-taking firm. The firm maximizes profit so that marginal cost equals price. P = TC’(Q) = MC(Q)

26. The equimarginal principle The equimarginal principle: If an activity is worth doing at all, it should be pursued until the marginal benefit of the activity equals the marginal cost of the activity. For businesses: If a firm decides to produce at all, it maximizes its net benefit by producing a quantity for which its marginal benefit equals its marginal cost.

27. Choosing a Quantity to Produce • Let the New Kids on the Block Record Company face the following demand and costs • New Kids can sell all the CDs they want for $12 per CD • The total cost of producing CDs is 2q2, where q is the quantity of CDs produced. • What is the optimal price quantity of NKOTB CD’s to produce to maximize this firm’s profits?

28. Choosing a Quantity to Produce Profit =12Q-2Q^2 0=12-4*2Q=12-4Q  12=4Q Q=3 Marginal Revenue=12 = 4Q = Marginal Cost

29. Discussion: Run this business Mikaela Ziegler, 7, and her 4-year-old sister, Annika run a refreshment business in St. Paul. They can sell as much pop as they want for $1.00 per unit by the fair each year. Total cost are 0.1x2 , x=number of units sold How much should they sell? (What is the best x?) At what price? What are annual profits?

30. Discussion: Now there is a $60 annual license fee in St. Paul Mikaela Ziegler, 7, and her 4-year-old sister, Annika run a refreshment business in St. Paul. They can sell as much pop as they want for $1.00 per unit by the fair each year. Total costs are 0.1x2 + $60.00 Annual License How much should they sell? (what is the best x?) At what price? What are annual profits?

31. Should ACME Inc, discontinue gadget production? Overhead of $120 is allocated equally to each product. On a full cost basis gadgets are sustaining a loss.

32. Vulcan Steel Vulcan Steel is the only manufacturer of steel in Rexville. Trade barriers make it impossible for foreign competitors to import steal into Rexville. Vulcan sells steel for $680 per ton domestically. The world price of steel is only $375 per ton. The average cost of producing steel at Vulcan is always at least $400 per ton. Should Vulcan consider exporting steel? Or should it focus on the profitable domestic steel market?

33. Consumer Optimization Objective: Utility = f(Food, Clothing) (what assumption is inherent in this expression?) Indifference curves • show more preferred bundles to less preferred bundles Constraint: Budget constraint Shows limits on feasible consumption bundles Utility Maximization: Maximize Utility subject to the budget constraint

34. Indifference curves Given a utility function U=f(X,Y) Indifference curves portray the marginal tradeoffs between X and Y that maintain a constant U

35. Indifference curvesdiagram

36. The budget constraint • I  PfF + PcC • which can be rearranged as • F  I/Pf - (Pc/Pf)C • and this can be drawn as …

37. The budget constraintdiagram

38. Shifting the budget constraint

39. Changing a price

40. Combining indifference curves and the budget constraint

41. Changing the price of food

42. Hypothetical constraint at Merrill Lynch

43. Optimal Merrill Lynch analyst choice: two different compensation plans

44. Alternative models of behavior Happy-is-productive promote employee satisfaction Good citizen communicate, facilitate, and praise Product of the environment hire the right people Economic model change relevant costs and benefits

45. Discussion: Interwest HealthCare, p. 37 What are the potential sources of the problem? What information would you want to analyze? What actions would you recommend to increase the accuracy of data entry? How does your view of behavior affect how you might address this assignment?

46. Looking Forward Read Managerial Economics Chapter3 Moneyball Lincoln Electric (A) and (B) Navy Turns Into Auctioneer, WSJ Its Just a Game, NYT Lincoln Electric Questions • Identify the objective and subjective components of the evaluation system. • How did the subjective components of the evaluation system add to the integrity of Lincoln's rewards/evaluation scheme? • What value-enhancing decisions and behaviors were motivated by Lincoln’s rewards/evaluation scheme? Navy Questions • Why does the Navy care about whether sailors like their location? • Should this program be terminated or expanded into other services?

47. Boxes Ltd. in isolated Sunrise Beach Texas • Shrinking working age population • Problems with hiring enough workers, despite $10 per hour wage (twice local going rate) • Needs to increase hours worked to meet its growing demand for boxes and production targets. • The new manager launched a daily overtime wage of $15 per hour for hours worked in excess of 8 per day? • Why did the new manager institute the overtime plan instead of simply raising the wage rate in an attempt to attract more workers to the firm?